1. Chapter 5. Corporate Distributions Howard Godfrey, Ph.D., CPA Professor of Accounting Updated January 31, 2012 Copyright 2012

2. The student should be able to: 1.Compute current earnings and profits (E&P). Pg-3 2.Understand the difference between current and accumulated E&P. Pg-8 3.Determine the tax consequences of nonliquidating cash distributions and property distributions. Pg-10+ 4.Determine the tax consequences of stock dividends and distributions of stock rights. Pg-18+

3. 1. Calculate current earnings & profits (E&P).

4. Nonliquidating Distributions - General. A distribution can be in money, securities, or any other property except stock or stock rights of the distributing corporation. As a result of the 2003 Act, qualified dividends received by a noncorporate shareholder are temporarily subject to a maximum tax rate of 15%.

5. 5 Nonliquidating Dist. in General. Cont’d 1. Shareholder includes in gross income as a dividend any nonliquidating distribution by a corp to the extent that it is out of earnings and profits (E&P). 2. To the extent a distribution exceeds E&P, it is a return of capital and reduces the shareholder's basis in his stock. 3. To the extent that a distribution exceeds E&P and stock basis, gain is recognized that is a capital gain if the stock is a capital asset in the shareholder's hands. Sections 301(a), 301( c) and 316

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10. 10 Bob-Stock Redemption – 1 of 2 Jan. 2, 2011. An investor (Bob) paid $40,000 for all 4,000 shares of newly organized ABC Corporation. Price: $10 per share Jan. 3, 2011. Bob found that ABC would not need the entire $40,000 for its initial asset acquisitions. Jan. 3, 2011. Bob sold 1,000 of his shares back to the corporation at his cost of $10 per share, or a total of $10,000. ABC had taxable income (and E&P) of $100,000 for 2011, and made no further distributions to Bob. How does Bob treat the Redemption?

11. 11 Bob-Stock Redemption – 2 of 2 The redemption will be treated as a dividend of $10,000. Bob will not be able to show that this is “not essentially equivalent to a dividend.” [70-1 USTC ¶9289]United States, Petitioner v. Maclin P. Davis] Sec. 302(a) and (b)(1)

12. 12 Sue’s Investment – 1 of 2 Jan. 2, 2011. An investor (Sue) paid $40,000 for all 1,000 shares of new ABC Corporation In 2011, ABC had a net loss (and deficit E&P) of $100,000. In 2011, ABC had a net profit (and E&P) of $20,000. January 1, 2011. Sue received a distribution of $10,000. How does Sue report the distribution?

13. 13 Sue’s Investment – 2 of 2 Sue will report dividend income of $10,000, because it is covered by current earnings and profits. Sec. 301, 316(a)

14. 14 Two Blocks of Stock- 1 of 2 Investor purchased 1,000 shares of ABC Corp at $40 per share and an additional 1,000 shares at $50 per share. (Total cost of $90,000) ABC has no current or Accum. E &P, but makes a distribution of $44 per share ($88,000). What is impact on investor?

15. 15 Two Blocks of Stock- 2 of 2 Total distribution does not exceed total basis, and there is no E&P. However, you must compute the gain using each block of stock (you may not combine the two blocks of stock). W.Taylor Johnson, 71-7 USTC 9148 435 F. 2d 1257 reversing 303 F. Supp. 1, 69-2 USTC 9602

16. 16 Lan Corporation 1 of 2 Lan Corp. made a $40,000 cash distribution to its sole shareholder this year. Lan’s current year E&P (as of the close of the year and without reduction for distributions during the year) is $25,000. Accumulated E&P from prior years is $10,000. What amount of dividend should be reported on Form 1099-DIV issued to the shareholder for the year? a. $ 40,000. b. $ 5,000. c. $ 0. d. $35,000.

17. 17 Lan Corporation 2 of 2 What amount of dividend should be reported on Form 1099-DIV issued to the shareholder for the year? d. $35,000. Does it make a difference if the dividend is paid on January 1, before the company has current earnings? No.

18. 18 Earnings and Profits. The term E&P is not defined in the Code. Its meaning must be determined from judicial decisions, Treasury regulations, and some rules provided in the Code. The purpose is to measure a corporation's economic ability to pay dividends.

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25. 25 Note about preceding slide. The preceding slide illustrates the concept that the installment sales method is not used for E&P purposes, even if it is used for regular income tax purposes. (Sec. 312(n)(5)). Same for completed contract method. [Sec. 312(n)(6)] [In many situations the installment method is not allowed to be used for regular income tax purposes.]

26. 2. Understand the difference between current and accumulated E&P.

27. Current E&P. E&P consists of two parts - current and accumulated E&P. Current E&P is calculated annually. Accumulated E&P is the sum of undistributed current E&P for all prior tax years less distributions made out of accumulated E&P and prior year current E&P deficits. Distributions come first from current E&P and then from accumulated E&P if current E&P is insufficient.

28. 28 Computing Current E&P. The starting point for computing current E&P is the corporation's taxable income or NOL for the year. This must be adjusted to arrive at economic income or loss (current E&P) for the year. Page 7 provides a partial listing of the adjustments that must be made to taxable income to derive current E&P.

29. 29 Income Excluded from Taxable Income but Included in E&P. Income that is specifically excluded from gross income must be included in current E&P if it increases the corporation's ability to pay a dividend and is not a contribution of capital.

30. 30 Income Deferred to a Later Period. Gains and losses on property transactions are often included in E&P when they are recognized for tax purposes. Exception: installment sales. Gain is recognized in the year of sale for E&P purposes in the case of an installment sale.

31. 31 Income and Deduction Items That Must be Recomputed When Computing E&P. Tangible personal property must be depreciated using the alternative depreciation system for E&P purposes. Realty is depreciated using the straight-line method over 40 years. Other adjustments must be made for percentage depletion, intangible drilling costs and the completed contract method of accounting.

32. 32 Deductions That Reduce Taxable Income But Are Not Allowed in Computing E&P. Some deductions claimed in computing taxable income are not allowed when computing E&P. These include the dividends-received deduction, NOL carryovers, charitable contribution carryovers, and capital loss carryovers from other tax years.

33. Expenses and Losses that are not Deductible in Computing Taxable Income but that Reduce E&P. When computing E&P, federal income taxes are deductible in the year accrued or paid. Charitable contributions are deductible without regard to the 10% limitation. Other deductible items for E&P purposes are life insurance premiums on key employees, capital losses in excess of capital gains, nondeductible expenses incurred to earn tax-exempt income, losses on sales to related parties, & nondeductible fines, penalties and political contributions.

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36. 36 Note that a distribution reduces E&P down to zero, but may not push E&P into a negative amount. Sec. 312(a) (to the extent)

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46. 46 Current vs. Accumulated E&P. Nonliquidating distributions are treated as coming first out of current E&P. When distributions exceed current E&P, current E&P is allocated to distributions on a pro rata basis regardless of when in the year the distributions were made. Distributions in excess of current E&P are deemed to come from accumulated E&P in chronological order. Distributions in excess of accumulated E&P are treated as a return of capital and reduce the shareholder's basis in their stock (but not below zero). These distributions do not create an E&P deficit. Deficits arise only because of losses.

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51. 51 Stock bought after dividend declared On January 2, 2011, an investor purchased, 1,000 shares of ABC stock at $40 per share. On January 10, 2011 the investor received dividends of $2 per share, declared on December 1, 2010, payable to stockholders of record on January 5, 2011. How does the investor report this $2,000 – as income or as return of capital?

52. 52 Stock bought after dividend declared Sec. 301 focuses on payment of the dividend, not declaration of the dividend. See also Reg. 1.61-9(c)

53. When is Dividend Reported? A dividend check is received on January 2, 2010. Dividend was declared on December 1, 2009, payable to stockholders of record on December 15, 2009, with check written and mailed on December 31, 2009? Reg. 1.451-2(b)

54. 54 3. Determine the tax consequences of non-liquidating Cash and Non- Cash property distributions.

55. 55 Consequences of Nonliquidating Property Distributions to the Shareholders. Property is defined as money, securities, and any other property except stock or stock rights of the corporation making the distribution. Amount of a distribution is generally the amount of money plus the FMV of any nonmoney property received. Any liability assumed reduces the amount of the distribution, but not below zero. Distribution is considered a dividend to the extent that it is out of E&P. Shareholder's basis in the property is its FMV unreduced by liabilities assumed. Holding period begins on the day after the distribution date.

56. 56 Consequences of Property Distributions to the Distributing Corporation. A corporation must recognize gain when it distributes property that has appreciated in value. Sec. 311(b). A loss will not be recognized on a nonliquidating distribution of property that has declined in value. If distributed property is subject to a liability or the shareholder assumes a liability in connection with the distribution, the FMV of the property is deemed to be at least equal to the amount of the liability.

57. 57 Consequences of Property Distributions to Distributing Corporation. Gain recognized is taxable to the corp. and results in an increase in E&P equal to the E&P gain which is the excess of the property’s FMV over its adjusted basis for E&P purposes. E&P gain may differ from the corp.’s recognized gain (for income tax purpose) upon distribution.

58. 58 Consequences of Property Distributions to the Distributing Corporation. If the adjusted basis of the noncash asset that is distributed equals or exceeds its FMV, E&P is reduced by the asset’s adjusted basis. If the FMV of asset distributed exceeds its adj. basis, E&P is reduced by asset's FMV. In either case the E&P reduction is net of: (1) any liability that the asset is subject to or which is assumed by the shareholder in connection with the distribution, and (2) the income taxes incurred on the gain recognized.

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61. 61 Property Distributions- Red Corp. -1 On 12-31-2011, Red Corp. distributed land to Mr. Smith (its sole shareholder). Adjusted basis of land$ 6,500 Fair Market Value of land14,000 Mortgage on land5,000 For year ended 12-31-2011, Red had E&P of $50,000. How much dividend income is recognized by Mr. Smith? a. $1,500 b. $6,500 c. $9,000 d. $14,000 e. none of these Reg. 1.301-1(g), Sec. 301

62. 62 Property Distributions- Red Corp. -2 On 12-31-2011, Red Corp. distributed land to Mr. Smith (its sole shareholder). Adjusted basis of land$ 6,500 Fair Market Value of land14,000 Mortgage on land5,000 For year ended 12-31-2011, Red had E&P of $50,000. How much dividend income is recognized by Mr. Smith? c. $9,000 Reg. 1.301-1(g), Sec. 301

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69. 69 Morris - Non-Cash Property Dividend -1 Morris Corp. has current E&P of $100,000. It distributes land with a FMV of $30,000 and basis of $10,000 to its sole shareholder, Mary, who has $70,000 basis in her Morris Corp. stock. This is not a liquidation or redemption. Which statement is true? a. Morris will recognize gain of $20,000 and Mary a taxable dividend of $20,000. b. Morris will recognize gain of $20,000 and Mary a taxable dividend of $30,000. c. Morris will recognize gain of $20,000 and Mary will have a non-taxable return of capital reducing her basis by $30,000. d. None of the above.

70. 70 Morris - Non-Cash Property Dividend -2 Morris Corp. has current E&P of $100,000. It distributes land with a FMV of $30,000 and basis of $10,000 to its sole shareholder, Mary, who has $70,000 basis in her Morris Corp. stock. This is not a liquidation or redemption. Which statement is true? b. Morris will recognize gain of $20,000 and Mary a taxable dividend of $30,000.

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73. 73 In the next three examples, Earnings and profits are more than enough to cover the dividend paid, so it does not change our answers when we ignore that gain on distribution of property results in an income tax liability on that gain, and that tax is a reduction in E&P.

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80. 80 West Corporation - 1 West Corp. distributes land with a basis of $1,000 and FMV of $4,000 subject to a debt of $6,000 to Jeff, a shareholder. What gain or loss must West recognize from the distribution? a. $3,000 gain. b. $1,000 loss. c. $5,000 gain. d. $ - 0 -. §311(b)(1), §311(b)(2) and 336(b).

81. 81 West Corporation - 2 West Corp. distributes property with a basis of $1,000 and FMV of $4,000 subject to a debt of $6,000 to Jeff, a shareholder. What gain or loss must West recognize from the distribution? c. $5,000 gain. §311(b)(1), §311(b)(2) and 336(b).

85. 85 Constructive Dividends. A constructive dividend is an indirect payment to a shareholder without the benefit of a formal dividend declaration. They usually arise in the context of a closely held corporation.

86. Intentional Efforts to Avoid Dividend Treatment. Excessive salaries or loans to shareholders are often devices used to avoid dividend treatment while benefiting the shareholder. They may be reclassified as a dividend, fully taxable to the shareholder and not deductible by the corporation in computing its taxable income. With the “current” reduced rate on dividends, the corporation will still lose the deduction on reclassification. Shareholder/employee will obtain a partially offsetting tax reduction on the dividend, for example, from 35% on compensation to 15% on the dividend. Dividend will not be subject to incremental payroll taxes.

87. 87 Unintentional Constructive Dividend Shareholders are not always aware that the benefits that they are receiving are really constructive dividends. When they are discovered by the IRS or a tax advisor, the books and records of both the corporation and the shareholder will have to be adjusted. A CPA should always be an advocate for his client if the question of whether a constructive dividend has been paid or not is in doubt.

88. Loans to Shareholders Loans to shareholders will be considered disguised dividends unless it can be shown that the loan is bona fide and the shareholder intends to repay it. If inadequate interest is charged, interest is imputed on the loan. The corporation will report interest income from the loan and the shareholder may have a deduction for interest deemed paid. The imputed interest is treated as a dividend paid to the shareholder, thereby resulting in no offsetting deduction for the corporation.

89. 89 Excessive Compensation Paid to Shareholder-Employees. Excessive compensation received by a shareholder-employee is generally treated as a dividend. Excessive Compensation Paid to Shareholders for the Use of Shareholder Property. Rents, interest and royalties that are paid to shareholders which are excessive in amount are generally recast as constructive dividends.

90. 90 Corporate Payments for the Shareholder's Benefit. If a corporation pays a shareholder's personal obligation, the payment may be treated as a constructive dividend. Disallowed corporate deductions may also be treated as constructive dividends. Bargain Purchase of Corporate Property. If a shareholder purchases property from a corporation for less than its FMV, the discount amount may be treated as a constructive dividend.

91. 91 Shareholder Use of Corporate Property. If a shareholder is allowed to use corporate property (e.g., an automobile, airplane or yacht) without paying adequate compensation to the corporation, the FMV of such use (minus any amounts paid) may be a constructive dividend to the shareholder.

92. Effect of Unreasonable Salary? -1 Corp reported taxable income of $500,000 for the year, after deducting salary of $300,000 to the owner. The IRS determined that reasonable comp. was $200,000. Ignoring payroll taxes, what is the effect of this IRS action on taxable income of Corp and Gross income of owner? For CorporationFor Owner a. Increase No effect b.Increase Increase c.DecreaseDecrease

93. Effect of Unreasonable Salary? -2 Corp reported taxable income of $500,000 for 2009, after deducting salary of $300,000 to the owner. The IRS determined that reasonable comp. was $200,000. Ignoring payroll taxes, what is the effect of this IRS action on taxable income of Corp and Gross income of owner? CorporationOwner a. Increase No effect However, dividend income will have 15% max rate.

94. 94 Excessive Salary-1 XYZ is a successful C corp. with substantial earnings and profits. When the IRS determines that XYZ's salary to its major shareholder is unreasonably high, the resulting audit adjustments will have the following effect(s): a. Increased revenue on the corporate return for XYZ b. Decreased deductions on the corporate return for XYZ c. Increased income on the non-corporate stockholder's returns d. Decreased income on the non-corporate stockholder's returns e. Both b and c

95. 95 Excessive Salary-2 XYZ is a successful C corp. with substantial earnings and profits. When the IRS determines that XYZ's salary to its major shareholder is unreasonably high, the resulting audit adjustments will have the following effect(s): b. Decreased deductions on the corporate return for XYZ

96. 96 A.M. Medlin, T.C. Memo. 1998-378. Medlin owns profitable auto dealership. Medlin is president and wife has served as V.P. (non- owner) for many years. They have recently divorced. Under the terms of the divorce, wife gets: Some investment real estate valued at $1,000,000. A new automobile each year until she dies or remarries. Dealership will pay the annual lease costs ($10,000 per year on the auto) and the auto insurance ($4,000 per year) for auto provided to her.

97. 97 A.M. Medlin Cont’d – Constructive Dividend … Under the terms of the divorce, wife gets: Coverage for medical, accident, and life insurance. She will be covered by group policy at the dealership, and in the event that the coverage must be discontinued, dealership will purchase separate individual policies that continue her current coverage. The cost of such coverage is about $5,000 per year. Client and former spouse have asked you for tax advice regarding these transactions.

98. 4. Determine the tax consequences of stock dividends and distributions of stock rights.

99. 99 Stock Dividends and Stock Rights. In 1919, the Supreme Court ruled in Eisner v. Macomber that a stock dividend was not income to the shareholder because it took nothing from the property of the corporation and added nothing to the property of the shareholder. This is the general rule today with some exceptions for tax-avoidance schemes. The dividend is taxable when a stock dividend has the potential to change the shareholder's proportionate interest in the distributing corporation.

100. 100 Tax-free Stock Dividends. § 305, 307 If a stock dividend is nontaxable, the basis of the stock with respect to which the distribution is made must be allocated between the old and new stock in proportion to their relative FMVs on the distribution date. The holding period of the new shares includes the holding period of the old shares.

101. 101 Tax-free Stock Rights. -1 § 305, 307 A distribution of stock rights is tax-free unless it has the potential to change the shareholders' proportionate interests in the distributing corporation. If the value of the stock rights is less than 15% of the value of the stock with respect to which the rights were distributed, the basis of the rights is zero unless the shareholders elect to allocate basis to those rights. If the value of the rights is 15% or more of the value of the underlying stock, the shareholder must allocate the basis of the stock between the stock and the stock rights based on the relative FMVs of the stock and stock rights.

102. 102 Tax-free Stock Rights. -2 If the stock rights are sold, gain or loss is measured by subtracting the allocated basis of the rights (if any) from the sale price. If the rights are exercised, the basis allocated to the rights is added to the basis of the stock purchased with those rights. If basis is allocated to the rights and the rights are allowed to lapse, the allocated basis is returned to the underlying shares. No loss can be claimed.

103. 103 Effect of Nontaxable Stock Dividends on the Distributing Corporation. Nontaxable distributions of stock or stock rights have no effect on the distributing corporation. The corporation does not recognize any gain or loss on the distribution and its E&P is unaffected. Please note that, for financial accounting purposes, stock dividends may reduce retained earnings.

104. 104 Taxable Stock Dividends & Stock Rights. If the distribution is taxable, the amount of the distribution equals the FMV of the stock or stock rights that are distributed on the distribution date. It is a dividend to the extent it is made out of E&P.

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107. 107 Which of the following statements regarding distributions of stock is not true? a.Distributions of stock and stock rights are never treated as property. b. Stock rights are distributions by a corporation of rights to acquire its stock. c.Distributions of stock dividends and stock rights are generally tax free to shareholders. d.Expenses of issuing a stock dividend are not deductible but must be capitalized.

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111. 111 Effect of Stock Div. on E&P?-1 A corporation has 1,000 shares of $100 par outstanding. Stock (1,000 shares)$100,000 Retained Earnings$100,000 FMV per share $200 May the corporation pay a 50% stock dividend (500 shares) and eliminate E&P? And later pay a tax-free cash dividend of $100,000?

112. 112 Effect of Stock Div. on E&P?-2 A corporation has 1,000 shares of $100 par outstanding. Stock (1,000 shares)$100,000 Retained Earnings$100,000 FMV per share $200 May the corporation pay a 50% stock dividend (500 shares) and eliminate E&P? And later pay a tax-free cash dividend of $100,000? NO. Sec. 312(d)

113. The End